Quick Take: National Oilwell Varco (NOV)

Oct 23, 2008

National Oilwell Varco (NOV) is the #1 provider of oil and natural gas drilling equipment worldwide. The company operates in 3 segments. Rig Technology (56% of 2007 sales, 63% of operating profits) provides systems and components for both land and offshore drilling rigs. Petroleum Services and Supplies (30%; 33%) is the more consumable portion of the business, providing repeat sales such as motors, pumps, and so forth. Distribution Services (14%; 4%) provides a distribution service center network to get parts out to customers quickly. NOV added to it's Services and Supplies segment in a big way back in April by acquiring drill pipe and bit supplier Grant Prideco in a $7.2 billion dollar deal.

The secular tailwinds of higher oil prices have driven increased exploration for oil, much of it in hard to reach places such as deepwater sites. This has led to significant increases in demand for drilling equipment. The decrepit existing drilling rig fleet (the vast majority are over 20 years old) is being upgraded with the huge cash flows coming in to operators. Demand for new deep water rigs has increased 5-fold over the last few years.

These demand tailwinds greatly benefit NOV. The company is far and away the top supplier of rig equipment. Order backlogs continue to be up nearly 50% over 2007 as drilling activity continues to heat up. Although the segment consists of a wide variety of parts and equipment, NOV supplies nearly everything, giving the company an estimated 60% share for the entire market, which is pretty phenomenal. Grant Prideco commanded nearly half of the drill pipe and about 10% of the drill bit market before being acquired - this will only add to market share. The company estimates that over 90% of all existing rigs have at least some NOV supplied parts on them. This dominance and scale give the company a substantial competitive moat. With a commanding scale, NOV can afford to under price competitors, provides a larger distribution network to expedite orders, and can offer solutions for multiple needs in a one-stop shop. This last point is important, as large customers prefer to deal with one supplier, as it simplifies logistics and also provides the opportunity for volume discounts.

Financially, NOV has acceptable metrics. Trailing MFI return on capital is solid at 57%, and free cash margin is a very good 17%. The net debt position is low, as the balance sheet shows 1.6B in cash vs. 1.7B in debt. Acquisitions and macro tail-winds have allowed NOV to increase revenues at a 19% clip, and operating earnings at a staggering 92% compound rate per year since 2003.

It would seem that National Oilwell Varco would make a decent Top Buy pick, and in fact I do think this stock has a good opportunity to show gains over the next year. However, a few things concern me enough to hold back a formal recommendation. Most importantly is the volatile nature of drilling demand, mainly related to the wide swings in the price of crude oil. While NOV has great financial statistics over the past year, with oil prices near or over the $100 mark, in more normal times MFI return on capital has averaged under 20% - not exceptional. Free cash flow has often come in negative in those periods. While it seems absurd to say today that oil will reach it's long term inflation-adjusted average of $33 a barrel, it's far from out of the question. An intense and widespread focus on extracting new sources of oil combined with a government-led move to alternative sources could easily lead to an over-supplied market, similar to the move from high prices in the late 70's to dirt cheap prices in the mid 80's. It's also sobering to remember the hundreds of oil equipment companies that went out of business in that period. NOV has a very high fixed cost component with large capital expenditure requirements, so lower revenues can lead to drastically lower profits.

Still, this is not a bad MFI pick. NOV has strong competitive advantages, a large backlog of orders, and so far still strong pricing in crude oil to hold up demand for drilling equipment. A fine choice for those looking for a play on a secular trend of higher oil prices.

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